This is indeed a pretty complex topic. However, we are of the opinion that inflation is (in the words of Milton Friedman) "always and everywhere a monetary phenomenon"—too much money chasing too few goods.

We do not believe that inflation is a near-term problem. While the money supply has grown in the form of banking reserves (through the various asset purchase programs, Quantitative Easing I & II), much of that money remains as excess reserves on deposit with the Fed. In other words, the money is not getting out or circulating. That is also evidenced by the velocity of money still being negative. The demand for money is not there. Therefore, if you apply the simple dynamics of supply and demand, inflation cannot really take hold.

QE I was primarily designed to stabilize the financial markets and also to fight the possibility of deflation (severe recession or depression). QE II was implemented toward the end of 2010 when it appeared we were feeling some deflationary pressures. Both did accomplish the objective of reversing some of the deflationary pressures in the market. The first was more effective than the second. However, they have not been able to reverse the trend for employment and that's where some of the disagreement lies within the FOMC—whether more accommodation in monetary policy will have a greater marginal impact on employment or on possible inflation.

This is not a normal business cycle. So, the effects of monetary policy on the overall economy will also most likely be different.

Here are the reasons why some of the structural hurdles will keep inflation expectations low:

  • Unemployment is still at high levels – approximately 9%, but slowly improving. However, we believe that the rate of unemployment is understated because of those who are currently not actively seeking employment and have really dropped out of the employment pool of potential workers. Furthermore, we expect the potential for increased unemployment from the public sector, as states and municipalities struggle with balancing budgets. These jobs will not be easily absorbed by the private sector.
  • Personal income continues to increase at a slow rate. Workers do not have the ability to demand higher wages in a labor market that has a great deal of slack (under-utilized). The biggest cost that most employers have is labor. Employment costs continue to be subdued.
  • Depressed housing values will continue to be an anchor against high inflationary pressures. The continued supply of existing home inventory is very high. This is still very much a recession in housing.
  • High indebtedness at all government levels means fiscal restraint will be necessary. In an economy that is driven by consumption of goods and services, the biggest consumers – governments – will be be reducing their discretionary expenditures. In many cases some municipal governments will be facing austerity budgets when it comes to discretionary spending. This is not going to be a short-lived problem. We would expect the fiscal imbalances of state and local governments to be a bigger problem next year as our economy continues to grow below its full potential.

Finally, Operation Twist is not really adding to the money supply. So, the Fed's balance sheet is not growing. They are merely extending maturities. Why? It is our opinion that they are trying to change consumer and investor behavior. As mentioned above, most of the money supply that was introduced into the banking system is still there in the form of excess reserves. The banks make money in a steep yield curve environment without really taking much marginal risk. By flattening the curve, (reducing long rates, since short rates are already zero) it should push banks to take additional marginal risks in order to make money. It also could stimulate demand for longer term financing by consumers and businesses because it is cheap.

Our opinion is that in a normal cycle this could work, but this cycle already has consumers and businesses deleveraging, and savings rates increasing. It is therefore unclear how effective this strategy will be. But, the majority of members of the FOMC believe that they have to comply with the dual mandate of stable prices and "full" employment. The risk is that by trying to affect the latter, the former could be negatively affected.

The dissenters at the FOMC do not necessarily believe that inflation risks are higher. They mostly believe that further accomodation will not have a major impact on employment and could have a negative effect on price stability in the future.